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Thread: Is the bond hangover cure of inflation WORSE than the disease?

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    Default Is the bond hangover cure of inflation WORSE than the disease?

    http://www.nakedcapitalism.com/2009/...inflation.html

    If the powers that be succeed in creating meaningful inflation, they will have to engineer a contraction to wring it out of the system. Volcker demonstrated how painful that could be. The retort is that the all in costs may well be worse that if we muddled along with less aggressive remedies.

    But human beings in general, and politicians in particular, do not discount future events the way finance textbooks say they ought to. They engage in hyperbolic discounting. So future costs are vastly cheaper than pain now, particularly if you can dump the mess on a successor.

    From the Financial Times:

    What I hear more and more, both from bankers and from economists, is that the only way to end our financial crisis is through inflation...

    Four immediate questions arise from these considerations. Can it be done? Can it be undone? Can it be done at a reasonable economic cost? Last, should it be done?

    Of course, it can be done, but only for as long as the commitment to higher inflation is credible. Inflation is not some lightbulb that a central bank can switch on and off. It works through expectations. If the Fed were to impose a long-term inflation target of, say, 6 per cent, then I am sure it would achieve that target eventually. People and markets might not find the new target credible at first but if the central bank were consistent, expectations would eventually adjust. In the end, workers would demand wage increases of at least 6 per cent each year and companies would strive to raise their prices by that amount.

    If, however, a central bank were to pre-announce that it was targeting 6 per cent inflation in 2010 and 2011, and 2 per cent thereafter, the plan would probably not succeed. We know that monetary policy affects inflation with long and variable lags. Such a degree of fine-tuning does not work in practice. My own guess is that one would have to make a much longer-term commitment to a higher rate of inflation for such a policy shift to be credible. I suspect that the greater the distance between the new rate and the current rate, the longer the commitment would have to be.

    Could it be reversed, once it had been achieved? Again, the answer is yes; again, the commitment would have to be credible....any new credibility would have to be earned through new policy action. This might imply nominal interest rates significantly above 6 per cent for an uncomfortably long period.

    What would happen then? I can think of two scenarios. The best outcome would be a simple double-dip recession. A two-year period of moderately high inflation might reduce the real value of debt by some 10 per cent. But there is also a downside. The benefit would be reduced, or possibly eliminated, by higher interest rates payable on loans, higher default rates and a further increase in bad debts. I would be very surprised if the balance of those factors were positive.

    In any case, this is not the most likely scenario. A policy to raise inflation could, if successful, trigger serious problems in the bond markets. Inflation is a transfer of wealth from creditors to debtors – essentially from China to the US. A rise in US inflation could easily lead to a pull-out of global investors from US bond markets. This would almost certainly trigger a crash in the dollar’s real effective exchange rate, which in turn would add further inflationary pressure.

    Under such a scenario, it might not be easy to keep inflation close to a hypothetical 6 per cent target. The result could be a vicious circle in which an overshooting inflation rate puts further pressure on the bond markets and the exchange rate. The outcome would be even worse than in the previous example. The central bank would eventually have to raise nominal rates aggressively to bring back stability. It would end up with the very opposite of what the advocates of a high inflation policy hope for. Real interest rates would not be significantly negative, but extremely positive.

    Should this be done? A credible inflation target of 2 or 3 per cent, maintained over a credibly long period of time, is useful. But I doubt that a 6 per cent inflation target could be simultaneously credible and sustainable. Tempting as it may be, it is a beggar-thy-neighbour policy unless replicated elsewhere and would come to be regarded as such by many countries in the world. It would produce a whole new group of losers, both inside and outside the US, with all its undesirable political, social, economic and financial implications. It would also fuel the already rampant discussions about the inevitable death of fiat money.

    Stimulating inflation is another dirty, quick-fix strategy, like so many of the bank rescue packages currently in operation. As Hemingway said, it would feel good for a time. But it would solve no problems and create new ones."

    "Stagflation was seen as impossible until it took place. I wonder if we could wind up with rising bond yields due to concerns about large fiscal deficits, with a lower rate of goods inflation due to the lack of cost push (wages are a significant component of the cost of most goods, save highly capital intensive ones). In fact, we could see stagnant nominal wages with mildly positive inflation, which means wage deflation. If that was also accompanied by high yields, you would have much of the bad effects of debt deflation per Irving Fisher (high real yields and reduced ability to service debt) since real incomes would be falling in the most indebted cohort. "

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    Default Re: Is the bond hangover cure of inflation WORSE than the disease?

    the 'tin foil hat' crowd would argue that this author stops short of exposing the REAL DEAL ... which is interest rates charged of borrowers are rising while interest rates paid to savers are falling, and the banks ( thus the gov't) pocketing the increased 'spread'. Similarly, prices charged for commodities are rising while earnings / wage levels are falling, with certain industries ( thus the gov't) pocketing the increased 'spread'.

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    Default Re: Is the bond hangover cure of inflation WORSE than the disease?

    the troubles are just starting ...



    (snip)"That's the Catch-22 threatening to make an awful housing market potentially worse and keep the economy stuck in a funk. Kick-starting the economy requires higher spending, but rising rates mean fewer Americans will be able to refinance their home loans. And some potential buyers will be shut out of the market by higher monthly payments they won't be able to afford.

    To understand how this is all connected, you have to think like a bond trader. Inflation is their enemy because it means the purchasing power of the dollars they receive when bonds eventually are paid off will be diminished. The only question is by how much.

    Yields on 10-year Treasury notes, a benchmark for home mortgages and other consumers loans, jumped from 2.5 percent in March around the time of the Fed announcement to as high as 3.7 percent in recent days as signs that efforts to stabilize the financial system and economy were starting to pay off. And 30-year mortgage rates jumped more than a quarter-point this week to 5.29 percent, the highest level since December, Freddie Mac reported.

    "If the meltdown continues in the bond market, then mortgage yields will soon be at levels that choke off refinancing activity," said economist Ed Yardeni, who runs his own investment firm. "Even worse, they could abort any necessary recovery in home sales and prices."

    Yardeni coined the term "bond vigilantes" in 1983 to describe how traders took matters into their own hands when they felt the Fed wasn't doing enough to fight inflation, which was running at an annual rate of more than 3 percent at that time.

    So what has set off the vigilantes this spring, at a time when the consumer price index is down at an annual rate of 0.7 percent?

    One explanation is that bond investors anticipate a greater supply of government debt being sold to fund federal spending. Investors are also increasingly fearful that the trillions of dollars the government will need to borrow in the coming years to finance the various stimulus programs will lead to a new bout of inflation.

    The White House estimates that the government will rack up an unprecedented $1.8 trillion budget deficit this year - more than four times last year's all-time high.

    "The bond market is calling the Federal Reserve out," said Mike Larson, a real estate analyst at Weiss Research Inc. in Jupiter, Fla. "Investors are saying that the Fed can't just print money out of thin air to finance a massive deficit."(snip)

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    Default Re: Is the bond hangover cure of inflation WORSE than the disease?

    SHY is down and TLT is up. Strange...

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    Default Re: Is the bond hangover cure of inflation WORSE than the disease?

    ^^^ I'd attribute that to US dollar exchange rate action re international investors.

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